Designing Auctions for the Pre-Salt’s

Designing Auctions for the Pre-Salt’s Production Sharing Agreements: Problems

and Solutions

Lucia Helena Salgado*(IPEA/UERJ)

International Workshop on Microeconomics applied to the Energy Industry

FGV-EPGE, Rio de Janeiro - December 16, 2011* with Gabriel F. Bragança, Eduardo P. Fiuza & Rafael P. de Morais

Why Auctions?

• Conceptually, auction is the recommended mechanism employed to allocate resources when dealing with assymmetric information on the value of the object, considering both the regulator and the potential players;

• In Brazil, oil and gas exploration and production contracts are auctioned since the Constitutional Ammendment 9/1995 and the Law 9478/1997.

Contributions of Auction Theory

The important issues in auction design are the same as the ones in competition policy: to avoid collusion, predation, entry-deterring behaviour, excessive concentration of market power (Klemperer, 2001);

Hence, from the public policy perspective, to identify the auction design that mitigate these problems is a crucial objective.

The Revenue Equivalence Theorem

• Starting point of Auction Design Theory: how violations of the Revenue Equivalence Theorem matter;

• This theorem states that there is no sistematic advantage in any mechanism design (the set of rules that governs the interaction among the parts);

• According to the basic model (independent private values), any single-stage or multi-stage game for allocating the unit among the n bidders will yeld the same expected payment by each bidder and the same expected revenue for the auctioneer;

• For an important set of auctions and environments, the average revenues and pays-offs of the bidders are exactly the same (Milgrom, 2004)

When the Irrelevancy Theorem is violated by reality

• In the real world, different auction models, depending on the specific situatios seem to generate different incentive structures and hence yield different results;

• There’s no such a thing as “one size fits all” in auction design – with empirical studies we realize that design matters (“Good auction design is not one size fits all and must be sensitive to the details of the context” Kemperer, 202);

• Even when there is a good understanding of the economic environment before the auction, the behaviour of the players cannot be treated as perfectly predictable (Milgrom, 2004)

The auction objectives

• The trade-off between objectives – eficiencies or revenue –is conceptually solved by Auction Theory, as both objectives tend to converge:

– Players that atribute higher value to the auctioned object tend to be the most capable of generating value;

– However, when market power is incorporated into the analysis, the coincidence of the goals of increased revenue generation and efficiency is compromised: higher bids for a player with market power may reflect its ability to raise prices, and not its productive efficiency.

Still the auction objectives

• Private values vs common values

– The first depends on the parties’ individual information and valuation over the object; the former depends on the real value of the object being the same to all the players (real world auctions mix private and common values);

• Oil and Gas auctions are typical examples of auctions of common values

– The quantity and the international price will be the same independent of the winner;

– In this environment, with few and big players, there is high risk of collusion;

– When assimetry of information is introduced in this environment, we face the risk of winner’s curse.

Still the auction objectives

• Some questions should be raised, but are frequently ommited:

– The auctionned object has been alocated in an efficient way?

– Do the auction rules promote competition?

– Does the auction promote dynamic competition, in the sense that it promotes the entry of new players, or at least do not generate entry barriers?

– Does the auction promote small firms?

• (Kemperer, 2000)

Empirical evidence of winner’s curse: the US case

Hendricks and Porter (1988), Hendricks, Porter and Wilson (1994) exploits the availability of ex post values to test equilibrium bidding models in common value environments with asymmetric information using drainage tract data;

Drainage tracts are adjacent to tracts where oil and gas deposits have been found. The firms owning the adjacent tracts, called “neighbour” firms, have superior information to non-neighbours about tract value;

The key feature of competitive bidding between informed and uninformed firms in first-price, common value auctions is that the latter participate, but their number is essentially irrelevant to the informed firm;

Since neighbour firms could be identified, and because they behaved as a consortium, it was possible to test the theory by comparing the bidding behaviour and the ex post profits of neighbour firms and non-neighbours.

Empirical evidence of winner’s curse: the US case

Hendrick, Pinkse and Porter (2003) conclude that the “winner’s curse” is evident in the data and that the bidders are aware of its presence and bid accordingly;

Bidding behaviour appears to be largely consistent with a symmetric CV environment, given our measure of potential competition and our measure of ex post returns;

Hendrick, Pinkse and Porter (2008) show that the trading inefficiency caused by the “winner’s curse” can be an important obstacle to collusion in auctions of common value assets with a binding reserve price or ex post investment.

Experimental research on common value auctions

Experimental research on CVAs has focused on the winner's curse: Kagel (1995), Avery and Kagel (1997), Kagel and Levin (2008), Levin, Kagel, and Richard (1996), Rose and Levin (in press), Rose and Kagel (in press);

The bottom line of these studies is that they confirm the problem of Winer’s Curse, but put in evidence the difference in magnitude, depending on the auction design.

Experimental research in colusion

Increasingly large experimental literature on the subject: Goswami, Noe and Rebello (1996), Sherstyuck (2002), Phillips, Menkhaus, and Coatney (2003), Sade, Schnitzlein, and Zender (2005) Li and Plott (2005), Offerman and Potters (2006), Brown, Kamp, and Plott (2007) and Kwasnica and Sherstyuk (in press).


All of the auctions considered here involved the same set of subjects competing in a series of auctions, usually with an unannounced end point;

Repetition with the same cohort appears to be a key (collusion) facilitating factor, a factor likely to be at play in field settings as well;

Communication between bidders reliably facilitates collusion (hardly surprising). As Whinston (2006) notes there is little in formal economic theory about the way in which prohibitions on (nonbinding) price agreements prevent anticompetitive prices, with the published empirical work offering surprisingly little evidence that preventing oligopolists from talking has a substantial effect on the prices they charge.


Sealed-bid, pay what you bid type auctions are more collusion-proof than ascending price auctions, which provide easier opportunities to detect and punish non-cooperators; Competitive pressures seem to play a role as well as suggested by the role played in breaking up collusion in LP and the role played (in the form of the support from which values were drawn) in Sherstyuk (2002).

What we have learned with our experience with oil and gas auctions so far in Brazil?

• Rules for the eight rounds of auctions that already took place:– First-price, sealed bid auction with multiple goals (blocks);

– A mix of simultaneous and sequential auctions – bids of one player to a set of blocks belonging to the same sector are gathered in one sealed bid auction;

– Only after the results of the auctions for one sector is known, the process of the following block begins (sequential auction)

– Bidding in packs are not allowed (for different blocks)

– The process is public and transparent, allowing for the organization of consortia, with or without the participation of the incumbent company(Petrobras).

– In the 8th round a restriction rule was introduced to the maximum number of blocks won by participants.

What we have learned with our experience with oil and gas auctions so far?

• In all the rounds, Petrobras’ participation was very expressive, varying between 38 and 84,1% of the auctioned areas. The firm’s success rate varied between 71,4% and 98,8% (rate tended to increase with each round);

• How to explain that success rate? “The predominance of offshore activity, the expertise of Petrobras and the relatively short time of opening” (Costa, Pastoriza e Prates, 2005) explains a great part of it.

What Theory of Auction would say otherwise?

• Refer to one factor: the winner's curse.

• When competing for the right to explore a field with an incumbent, under the rule of a sealed auction price, the players are subject to an extreme asymmetry of information;

• Petrobras has dealt with prospective research in Brazil for over 50 years. Winning an auction against it is almost certainly a bad deal (i.e. it means you the winner evaluated wrongly);

• Add to that the incumbent's market power: the participants have every reason to be cautious in their bids.

Recalling why the auction design matters

• The design of a first price sealed auction prevents participants from obtaining signals on the true value of the fields, when they are not able to observe the bids of other participants;

• If, on the one hand, the design minimized the risk of collusion, it maximized the problem of the winner's curse, making all other participants, other than the incumbent, overly cautious;

• Thus, sub-optimal result: although aiming at more competition we end up with less competition (and efficiency and revenues to the auctioneer) as one might expect from the theory.

What to expect of auction in the new regime?

In June 2010, the Brazilian Government waived Petrobras’ need for bidding for 5 billion barrels of oil of the pre-salt layers, that will be obtained instead through a bilateral contract called “onerous assignment”;

Moreover, with the enactment of Law No. 12,351 of December 22, 2010, it was determined that the pre-salt oil and gas fields will be explored according to a Production Sharing Agreement (PSA); In the PSA, the government retains ownership of production, and grants oil

companies a stipulated share as compensation for risks taken, services rendered, initial investment, and operation and maintenance costs.

The PSA, under the aforementioned law, can be signed: entirely by Petrobras, without the need of auctions;

or by a consortium that wins the auction for the area to be explored, that consortium being formed by Petrobras (at least 30% of it) and the winning company(ies).


The auction design becomes a main object of study.

The minimum guarantee of 30% for Petrobras will affect the incentives for consortia formation and bidding performance;

This can generate new outcomes, impacting not only bids and winners, but also the return for the government (as the auctioneer and also as a bidder through Petrobras).

Because of the specificities of Brazilian PSAs, concessions and onerous assignment, the asymmetries between the entities participating in a unitization agreement – when reservoir holders have boundaries other than those outlined in the contract, and have to operate the field jointly – also becomes a sensitive issue that requires further research.


It is necessary to evaluate the available auction design and even propose new ones – or combinations of existing ones;

It is not possible to advance by fine tune, building on previous mistakes. A well-defined framework is necessary to provide legal certainty to investors/bidders. Lab experiments will be crucial to test different designs;

It must be pointed that the model adopted so far facilitates detection and punishment (the two elements necessary to make a cartel work): simultaneity in a given block and sequenciality across blocks. Plus, increased winner’s curse due to 1st price sealed bid.

Possible solutions

The collusion’s problem in sequential auctions could be mitigated:

Lots’ designs which hamper the market’s division;

Rules imposition(including imposition of costs) which prohibit withdrawal of bids and their values;

Imposition of anonymity to the participants and/or to the bids.

The problem of the winner’s curse could be mitigated by the design of a hybrid auction, which enables learning (reduction of information asymmetry)

Sequential, ascending and open auction.

The winner´s curse is worse under the new rules

the problem of winner's curse is getting worse in the new regulatory framework for the pre-salt, since the share of the incumbent will be established politically (for strategic reasons);

If Petrobras had fixed 30% share, the collective information would be greater, which would decrease the uncertainty of the agents and possibly the winner's curse;

However, assuming that Petrobras is the agent most well informed, with great certainty of high profitability, the government starts to want to ensure wide participation in income from the block;

It is presumed that Petrobras will enter only between wells with minimum participation is very risky and uncertain. The rest knowing that a certain victory at auction may be due to a miscalculation (considering that would be more uninformed) may decide on participation / bid below the optimum.

Possible solutions

As we do not have empirical knowledge on outcomes of auction under this institucional environment, experimental economics may be crucial;

Which designs will be able to mitigate the winner’s curse problem.

thanks for your attention!

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Documents

Designing Auctions for the Pre-Salt’s